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Published at 20 Mealy's International Arbitration Report (May 2005) 39-43. Reproduced with permission of the authors.

An Arbitrator's Powers and Duties Under Art 114 of Chinese
Contract Law in Awarding Damages in China in Respect of
a Dispute Under a Contract Governed by CISG

Professor Marcus S Jacobs, QC and Yanming Huang [*]

DIGEST

Article 6 of CISG entitles the parties to a contract governed by the provisions of the Convention to opt out of any provision thereof.

This article discusses in an arbitration between a European party and a Chinese party in China whether a penalty clause (a liquidated damages clause) constitutes an opting out of the damages provisions in Articles 74-76 of the Convention, and the impact of Article 114 of the Chinese Contract Law on those facts.

  1. The assumed facts
  2. The relevant provisions of CISG
  3. There are no prohibitions in Chinese law against penalty clauses
  4. Considerations arising from the curial law or lex arbitri
  5. The penalty clause implies that the parties have opted out of Articles 74-76 of CISG
  6. Article 114 of Chinese Contract Law
  7. The Arbitral Tribunal's discretion in regard to the application of Article 114
  8. Conclusion

1. The assumed facts

     1.1 The facts below are based on, but not necessarily identical to the facts of a CIETAC arbitration. To avoid identification of the parties, no names will be provided in this article and the facts will be altered without affecting the thrust thereof.

     1.2 The purpose of this article is to discuss the impact of Article 114 of the Chinese Contract Law on an award for damages for breach of contract in an international commercial arbitration where, under Article 6 of CISG, there has been an implied opting out of the provisions contained in Articles 75 and 76 of CISG.

     1.3. The assumed facts are:

2. The relevant provisions Of CISG

     2.1 Under Article 6 of CISG, it is provided that:

"The parties may exclude the application of this Convention or, subject to Article 12, derogate from or vary the effect of any of its provisions."

     2.2 Under Article 74 of CISG, it is provided:

"Damages for breach of contract by one party consist of a sum equal to the loss, including loss of profit, suffered by the other party as a consequence of the breach. Such damages may not exceed the loss which the party in breach foresaw or ought to have foreseen at the time of the conclusion of the contract, in the light of the facts and matters of which he then knew or ought to have known, as a possible consequence of the breach of contract."

     2.3 Under Article 75 of CISG, it is provided:

"If the contract is avoided and if, in a reasonable manner and within a reasonable time after avoidance, the buyer has bought goods in replacement or the seller has resold the goods, the party claiming damages may recover the difference between the contract price and the price in the substitute transaction as well as any further damages recoverable under article 74."

     2.4 Under Article 76 of CISG, it is provided:

"(1) If the contract is avoided and there is a current price for the goods, the party claiming damages may, if he has not made a purchase or resale under article 75, recover the difference between the price fixed by the contract and the current price at the time of avoidance as well as any further damages recoverable under article 74. If, however, the party claiming damages has avoided the contract after taking over the goods, the current price at the time of such taking over shall be applied instead of the current price at the time of avoidance.

(2) For the purposes of the preceding paragraph, the current price is the price prevailing at the place where delivery of the goods should have been made or, if there is no current price at that place, the price at such other place as serves as a reasonable substitute, making due allowance for differences in the cost of transporting the goods."

3. There are no prohibitions in Chinese law against penalty clauses

     3.1 As held in the ICC Arbitration Award of March 1999 (Case No 9978), the validity of a penalty clause falls to be determined in accordance with the proper law of the contract which, in that case, was German law.

     3.2 Sieg Eiselen, in his October 2002 article "Remarks on the Manner in which the UNIDROIT Principles of International Commercial Contracts May be Used to Interpret or Supplement Article 74 of the CISG," says in sub-paragraph n, page 5 of 21, Unidroit 74 Database Directory, in "GUIDE TO ARTICLE 74" "Use of UNIDROIT Principles to help interpret CISG Article 74," the following:

"The CISG consciously does not deal with so-called liquidated damages and penalty clauses. The framers of the Convention agreed that the validity and application of such clauses were to be dealt with in terms of the applicable legal system due to widely divergent approaches in the different legal systems, Staudinger/Magnus, Art 74, Rn 59 & 60; Honsell/Sch nle Art 74, Rn 32; Witz/Salger/Lorenz, Art 74, Rn 42. Article 7.4.13 of the UNIDROIT Principles, however, is based on the validity of such clauses subject to a judicial discretion to reduce the amount where it is grossly excessive. The vagaries of private international law will therefore decide this issue and the UNIDROIT Principles cannot provide any interpretative assistance to the CISG, Russia 23 November 1994 Arbitration proceeding 251/1993, restricting the damages to the extent of the penalty clause."

     3.3 Mr Guiguo Wang, in his article The New Contract Law of China (2000) 15 JCL 242 at p 10, has written as follows:

"The Law permits the parties to agree liquidated damages for breach of contract. For instance, parties may fix an amount as penalty for breach of contract (Article 114 of the Contract Law. The parties concerned may also agree on a formula for calculating the amount). The liquidated damages clause becomes operational once a party expresses by words or acts not to perform the contract regardless of whether the period for performance has expired (The Contract Law, Article 108). If the penalty amount is less than the loss suffered including economic loss that is foreseeable at the conclusion of the contract, the party concerned may request the court or arbitration tribunal to raise the amount so that all losses can be covered (The Contract Law, Articles 113 and 114. The Law also provides that where the penalty amount is higher than the losses suffered, the defaulting party may request the court or arbitration tribunal to make appropriate reductions. The word appropriate clearly indicates the Law's preference for enforcing penalty clauses. Other laws may also apply in cases of breach of contract. In such cases if the other laws offer higher penalties, the party concerned may choose other laws. The Law on Consumer Protection is one such law). Penalties may also be agreed upon for delay of performance. This is new in Chinese contract practice. Under such circumstance, if any party fails to perform the contract in time, he must pay the penalty to the other party."

     3.4 It is interesting to note that Mr Guiguo Wang, in his article above, seems to elide the concepts of liquidated damages on the one hand and penalties on the other. He does not distinguish between the two concepts, which are clearly distinguishable in common law systems.

4. Considerations arising from the curial law or lex arbitri

     4.1 On the facts assumed above, the situs or the site of this Arbitration is Beijing, China.

     4.2 The curial law/the lex arbitri, ie the law of the situs or the site of the arbitration, viz, Chinese Law, determines the powers and duties of the arbitrators. This statement is supported by the highest authority, see, for example, Dalmia Dairy Industries Ltd v National Bank of Pakistan [1978] 2 Lloyds Reports 223 and 270. This statement also has the support of F A Mann in "State Contracts and International Arbitration" (1967) British Year Book of International Law 1 at p 4. The article published in "Contemporary Problems in International Law" edited by Dr Julian D M Lew, London 1986, 11 at p 131 under the heading 'The Law Governing the Agreement and Procedure in International Arbitration in England' with the subheading 'The Procedural Law of an Arbitration.' Please also refer to Klaus Peter Berger "Studies in Transnational Economic Law V9 International Economic Arbitration, Chapter 2 p 96 and, very importantly, "Commercial Arbitration" by Sir Michael J Musthill and Stewart C Boyd 2nd Edition p 62, where in the paragraph marked "2" the learned authors state:

"The curial law governs: the manner in which the reference is to be conducted; the procedural powers and duties of the arbitrator; questions of evidence; the determination of the proper law of the contract."

     4.3 This fact triggers the application of Article 114 of Chinese Contract Law above.

5. The penalty clause implies that the parties have opted out of Articles 74-76 of CISG

There is considerable authority for the proposition that by the adoption of a valid penalty clause, the parties have impliedly opted out of Articles 74-76 of CISG. Some case decisions are as follows:

(a) In the Tribunal of International Commercial Arbitration at the Russian Federation of Commerce, case number 251/903, in a decision of 23 November 1994, there was partial delivery of the commodity ordered. The contract contained a penalty clause. It was held that the buyer was not entitled to damages under CISG for an amount exceeding the amount of the penalty clause.

(b) In the Court of Appeal of Turku in Finland, it was held on 12 April 2002 that where the contract limited damages to be paid in the case of non performance, the buyer was not entitled to damages beyond those fixed by the contract terms.

(c) In the Gerechtshof's Arnhem, Netherlands, case number 94/305, on 22 August 1995,in the matter between Diepeveen-Dirkson BV v Nleuwenhoven Vichandel GmbH, it was held that no provision in CISG, not even Articles 8 or 77, provided a basis for reduction of a contractual penalty. Therefore, the question is to be solved according to the domestic law otherwise applicable to the contract.

(d) In the Rechtbank van Koophandel, Hasselt in Belgium, case number AR 1972/96, on 21 January 1997, in the matter between Epsilon BVBA v Interneon Valkenswaard BV, the Court upheld the validity of a penalty clause and applied domestic law and, by implication, Articles 74-76 of CISG were excluded.

(e) In the Arrondissementsrechtbank Arnhem, Netherlands, case number 1992/1251, on 30 December 1993, in the matter between Nleuwenhoven Vichandel GmbH v Diepeveen-Dirkson BV, a contractual penalty for late payment was upheld and, by implication, Articles 74-76 of CISG were excluded.

(f) In the ICC Court of Arbitration, case number 9978, March 1999, (parties unknown), there was the same result. The Tribunal held:

"As to the merits, the Arbitral Tribunal dismissed the buyer's claim concerning damages, stating that the inclusion of a penalty clause for non delivery prevented the buyer from invoking the provisions on damages laid down in Art. 74 CISG. In order to ascertain the validity of the penalty clause, since it is a matter excluded from CISG in accordance with its Art. 4, the Arbitral Tribunal referred to the domestic law otherwise applicable to the contract (i.e. German Law)."

6. Article 114 of the Chinese Contract Law

     6.1 A fair English translation of the relevant paragraph, Article 114 of the Chinese Contract Law, reads as follows:

"The parties may stipulate that in case of a breach of contract by either party a certain amount of penalty shall be paid to the other party according to the seriousness of the breach, and may also stipulate the method for calculating the sum of compensation for losses caused by the breach of contract.

If the stipulated penalty for breach of contract is lower than the loss caused by the breach, the party concerned may apply to a people's court or an arbitration institution for an increase. If the stipulated penalty for breach of contract is excessively higher than the loss caused by the breach, the party concerned may apply to a people's court or an arbitration institution for an appropriate reduction.

If the parties agree upon a penalty for the breach of contract by a delayed fulfillment, the breaching party shall, after paying the penalty for breach of contract, discharge the debts notwithstanding."

     6.2 The impact of Article 114 will be dealt with more fully below.

     6.3 Readjusting the damages, when it is too high or too low, should be done upon the request by a party to a case. The readjustment is a registration to the freedom of contract, but it could effectively correct unfairness and would be beneficial to the social economic order.[1]

7. The Arbitral Tribunal's discretion in regard to the application of Article 114

     7.1 Article 114 confers a discretion on the International Commercial Arbitration Tribunal as to whether or not the provisions of that article should be invoked.

     7.2 If there is merely a minor difference between the purchase price of the goods in the subject Contract and the current price at the relevant date at the relevant port, then the Tribunal's strong prima facie view is that it would not invoke Article 114. If however there is a substantial difference, the Tribunal would be persuaded to do so.

8. Conclusion

The following conclusion is reached in this article.

If there is a penalty clause (and this would include a provision for liquidated damages) in a contract to which CISG applies, this constitutes an opting out under Article 6 of Articles 74-76 of the Convention. If the arbitration has Chinese Law as the curial law of the arbitration, this triggers Article 114 above and, this in turn, gives the Arbitral Tribunal a discretion as to increasing or decreasing the amount of the penalty provided for in the contract.


FOOTNOTES

* Professor Marcus S. Jacobs is one of Her Majesty's Counsel for the State of New South Wales, Barrister, Sydney, New South Wales and the author of Commercial Arbitration, Law and Practice and International Commercial Arbitration in Australia, Law and Practice, an Adjunct Professor in the Law Faculty at the University of Technology, Sydney. Yangming Huang is an arbitrator of the China International Economic and Trade Arbitration Commission, a Panel Conciliator of the Conciliation Center of CCPIT/CCOIC and an Attorney.

1. Yang Zhenshan and Liang Shuwen (Chief Editors), The Fundaments and Application of the New Contract Law, the Publishing House of the Supreme People's Court of China, May 1999, p. 387.


Pace Law School Institute of International Commercial Law - Last updated September 12, 2005
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